If you are a US person living abroad, you are treated by the US tax authorities as operating your life in US dollars. This tax principle is known as ‘functional currency’, and is true whether you conduct some, or all, of your financial activities in a foreign currency.
So, what does a strengthening of the US dollar (USD) mean to you and your tax bill? The answer is that it could result in you making unintended financial gains which, sadly, come with tax consequences.
How can this happen?
When you buy an asset abroad, it is purchased in a foreign currency. For US tax purposes foreign currency is an asset that is potentially subject to tax like the disposition of any other asset.
To calculate the tax due on the disposal of an asset, US tax authorities translate the cost into USD using the exchange rate (FX) applicable at the time of acquisition.
Equally when selling an asset, the tax due from the sale, is converted from the foreign currency back into USD at the FX rate on that date.
When you buy or sell assets in the UK, and there is a strengthening of the US dollar against the pound, you could be making unintended financial gains because of the US ‘functional currency’ tax principle.
Not only this, but it’s possible that when you spend currency held either as cash or in a foreign bank account, this too could potentially be classed as a taxable transaction.
However, before you worry about using your non-US bank account for everyday use, there are de minimis rules that apply. These rules allow US persons living overseas to disregard small gains and losses on everyday transactions when spending that foreign currency, for example when buying groceries.
Notably, there is one common type of transaction caught by the principle of ‘functional currency’ which is currently creating taxable gains as a result of the appreciating US dollar (and the continued depreciation of sterling). That is the repayment of foreign mortgages and other debts.
Mortgages – a debt or an asset?
As mentioned above, foreign currency is treated as an asset for tax purposes, but how does this apply to a debt, which is a liability?
The taxable event occurs when the mortgage debt is repaid, which can also include re-mortgaging.
The simplest way to explain this, is to think about mortgages in the context of them being a debt like any other, and that this debt can be considered as a shorting of the foreign currency.
In the case of mortgages, the ‘proceeds’ are the amount borrowed with a USD value based on the FX rate at the time the funds are lent.
The cost basis is then the USD equivalent of the foreign currency when the mortgage is repaid.
So, an appreciating dollar is creating a foreign exchange gain.
On 1st June 2016 you borrow £500,000 at an FX rate 1.45 $ to £ which is a value of $725,000.
On 20 November 2019 you repay the £500,000 at an FX rate 1.25 $ to £ which is a value of $625,000.
You have created a taxable exchange gain of $100,000.
The rate of tax that applies is the ordinary income rate of up to 37%, plus a potential net investment income tax rate of 3.8%, equalling 40.8%. This means that the tax cost in this example could be as high as $40,800.
If the USD depreciates over the period of borrowing, this will create a foreign exchange loss, but this is not allowable, as it relates to personal property.
The mortgage is also treated as a separate asset from the property itself, so it is not possible to offset financial gains or losses from one against the other.
Therefore, if you are a US person living overseas and you are buying or selling a property abroad, or you are thinking about remortgaging, you may well make an unintended financial gain which could add significantly to your tax bill.
Is there any good news?
If your mortgage is in joint names and the joint-owner is not a US person, only 50% of the financial gain is taxable.
It may also be possible to offset the US tax payable with available foreign tax credits, depending on circumstances.
With the drop in the value of sterling and the potential for this to continue with the economic uncertainty, this is not particularly good news from a tax perspective. However, there may be some tax planning that can be undertaken to mitigate the worst of the unintended tax burden of buying or selling a property abroad.
As ever with personal tax, this is quite a complex issue, so if you have any questions about this, the best thing to do is to speak to your advisor or get in touch with myself using the contact details to the right – particularly if you are about to buy or sell a property or remortgage.
For more information, please contact Adam Smith.